Practical Guide to Asset Sensitivity
Banks use several techniques to convert some of their asset-sensitivity to current period earnings.
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Financial Institutions Case Study: Asset Liability Management
A regional bank with a newly issued brokered CD portfolio.
Our client was asset-sensitive and had just issued 5yr brokered CDs that paid a fixed rate of interest. The client lends to borrowers at a floating rate of interest plus a credit spread, with a nominal floor. The net interest margin (NIM) would benefit from rising rates in the future, but in the short-term NIM was compressed by the long-term funding rate relative to the floored variable rate loan portfolio.
Chatham Financial assisted the client with alternative hedging scenarios to reduce the impact of its relatively high, fixed-rate long-term funding. The client was considering a receive-fixed swap vs. a floating rate with sold floor based on the Prime rate, with the intention to designate the combined swap/floor against its floating rate commercial loan portfolio. Chatham’s analysis and price indications showed that the client would not realize substantial economic benefit from selling the floor in their loan portfolio – leaving significant value on the table. In addition, the client could not assert that it was probable that the hedged principal balance would be outstanding for the life of the swap, jeopardizing its ability to receive hedge accounting. As an alternative, Chatham proposed that the client execute a receive-fixed swap based on LIBOR without the embedded floor and designate the swap as a hedge of the fixed-rate liabilities.
The client executed the receive-fixed swap designated as a fair value hedge of the fixed-rate CDs. In so doing, the client converted its 5yr fixed rate funding back to a floating rate at 3-month LIBOR plus a spread, meeting their objective to relieve short-term pressure on their NIM.
Real Estate Case Study: Debt Ratio
A public real estate company specializing in asset management in the hospitality sector.
Our client had paid down a significant portion of their floating rate line of credit, leaving them with a fixed/floating rate debt ratio higher than they desired. With hotel assets essentially re-pricing daily, the client wanted to increase their floating rate exposure on the liabilities side to better match the characteristics of their assets.
We discussed entering into a receive-fixed swap to rebalance their fixed-floating mix. A secondary benefit of this strategy was that it allowed them to reduce their current interest expense due to the steepness of the yield curve; the receive fixed swap synthetically transformed a higher fixed rate obligation into a lower floating rate obligation, based on an historically low current LIBOR setting. Because this client is a public company, there were significant accounting considerations in determining which source of underlying debt to hedge, with the goal being to minimize any potential earnings impact the swap could have. As a fair value hedge, it was important to consider the term of the debt and the characteristics of their available bonds and/or mortgage debt. Common features, such as prepayment options, equity clawback provisions, and call options can create inefficiency or potentially preclude a client from applying hedge accounting and can lead to earnings volatility if not properly addressed.
The client was able to execute an effective hedge that achieved their desired fixed-floating profile. While the interest rate environment at the time made receive-fixed swaps an attractive product for many companies looking for upfront interest savings, in this case the company was positioned to take advantage of these savings as part of a larger risk management strategy.
Private Equity Case Study: Emerging Markets
A large private equity firm contemplating an emerging markets acquisition.
A private equity fund was in a competitive bid situation to acquire a retail store chain in Eastern Europe. While the deal appeared attractive in local currency, it was uncertain when translated in USD. In addition, hedging seemed unattractive because forward exchange rates reflected the deep depreciation of the local currency.
The investment team’s objective was to determine the most cost-effective hedging strategy, the likely key drivers of the local currency and the maximum exposure to their returns should their equity be unhedged. Chatham Financial was able to assist in exploring various hedging strategies including forwards, options and inflation-linked instruments. Also, we assisted in researching various macroeconomic data for the country to develop correlations against the investor’s base currency, modeling pro-forma financial statements using real (inflation adjusted) forward rates and quantifying the range of IRR and terminal value USD if the equity was unhedged.
Once the cost of hedging and risk of equity returns were considered, the firm was able to make an informed risk-adjusted bid for the business. While the firm ultimately lost the bid for the firm, the investment committee was able to establish firm norms and expectations around how to best evaluate bids in emerging markets.
Derivatives Regulation Case Study: Regulatory Compliance Assessment
A Fortune 100 technology company with international operations and multiple hedging programs involving exchange-traded and over-the-counter (OTC) derivatives across different asset classes, including foreign exchange, interest rates, and credit.
The company was concerned about the impact of new derivatives regulations on its hedging programs, including how the parent company and numerous subsidiaries might be classified under Title VII, what new regulatory requirements might apply, and the extent to which hedging costs may increase due to new regulatory requirements. The client’s hedging programs spanned multiple global regulatory jurisdictions and included several different entities including both financial and nonfinancial entities.
Chatham conducted an in-depth review of the hedging programs, spending two days onsite at the client’s premises to interview stakeholders within the company, including representatives from treasury, risk, operations, legal, and accounting. In addition, Chatham did a comprehensive assessment of the client’s use of derivatives and how the proposed OTC derivatives regulations could affect its derivatives risk management strategy in terms of work flow, transaction cost, liquidity, and operations.
Chatham completed and presented a comprehensive impact analysis to senior management which identified over a dozen areas of impact, including the extent to which inter-affiliate transactions would be regulated, the impact of clearing, and the applicability of certain exemptions under Title VII. Chatham proposed several potential solutions for the identified problem areas, and detailed over 30 action items for the client, including recommending specific modifications to hedging programs which could reduce the costs of regulatory compliance. Based on these findings, the client has initiated, in collaboration with Chatham, a corporate communications strategy and a full implementation plan of the actions to ensure full regulatory compliance.
Corporate Case Study: Tracking & Reporting for Hedges
A global musical instruments manufacturer and distributor who actively manages FX and interest rate risk exposures.
The company was managing over 1,500 derivative instruments in Excel and was applying hedge accounting for more than half of their derivatives portfolio. They were applying a hedge accounting methodology that caused some earnings volatility and wanted to evaluate whether another approach, such as regression for effectiveness assessment and hypothetical derivative method for measurement, could produce better results. The period end process was taking longer than our client wanted, and, unfortunately, it was necessary to enter and maintain every derivative into multiple systems or spreadsheets.
The company was seeking to implement a hedging, hedge accounting & derivative reporting solution that would:
- Ease the administrative burden of tracking and reporting derivative transactions
- Eliminate risk of errors in tracking and reporting portfolio performance
- Produce GAAP compliant valuations (including CVAs) in a timely manner each period end
- Integrate with the company’s other relevant systems
- Provide all hedge accounting designations, journal entries, effectiveness testing, disclosures, valuations and customized reporting in an automated and timely manner
The company sought Chatham’s hedging and hedge accounting technology solution in order to address the risks and objectives identified. We successfully loaded the company’s transactions into Chatham’s systems, including accounting treatments, journal entry balances, and valuation history, including CVAs. Chatham and the company worked in partnership to redesignate certain hedging instruments, apply methodologies that were more ideal for the goals and objectives of the company, and train the company treasury and finance staff in multiple areas.
From kickoff to complete implementation, including performance of parallel testing, the process took less than 4 months. Management’s goals were achieved and the company now has a seamless, easy to use, and best practice solution for all of their derivative needs.
Derivatives Regulation Case Study: Clearing Selection
A regional bank that uses derivatives for asset-liability management and offers hedges to its customers in connection with variable-rate loans.
The client, who will be required to centrally clear certain derivatives transactions, hired Chatham to evaluate and help in the selection of futures commission merchants (FCMs), with whom the client will need to establish a relationship in order to be able to access clearing houses for the central clearing of derivatives trades.
Chatham conducted an independent RFP (request-for-proposal) process for the client involving eight FCMs. The RFP assessed fee schedules, creditworthiness, initial margin estimates and complementary services available to customers. The client received a full analysis and evaluation of the FCM proposals customized to align with the client’s specific needs. The RFP evaluation was presented to the client’s senior management team which, based on these findings, was able to select the FCM that was ideally suited to their specific needs. The client, with Chatham’s guidance, is currently in the process of negotiating clearing-related documents to formalize the relationship.
Private Equity Case Study: Currency Challenges
A large private equity firm executing an acquisition in a developed economy.
A private equity consortium had agreed to acquire a North American company. Due to the state of debt capital markets, a substantial portion of the debt capital structure was denominated in USD with floating rates.
The consortium and company needed to determine the best way to address the currency mismatch between cash flow and interest expense, as well as the optimal way to create a higher percentage of fixed rate debt. Chatham Financial educated the team on the use of cross-currency swaps, created transparency in the execution process of the hedging transactions, and assisted in the negotiation of the key documentation for the derivatives to ensure no hedge counterparty stood ahead of other secured lenders to the business.
The consortium was able to remove the currency mismatch between cash flows and debt service, allowing the company to have certain interest expense despite the significant volatility of the exchange rate. In addition, Chatham’s involvement in the process ultimately saved the sponsors multiples of our fee at execution.
Corporate Case Study: Interest Expense & Currency Risk
A software firm with contracts in multiple currencies, a complicated legal structure and unique debt structures.
The company had recently increased leverage from a negligible amount to roughly 50% of its enterprise value in a recapitalization, compounding the currency risk. The company was trying to determine the best way to hedge its exposure to a CAD loan with interest payments based on a USD LIBOR index, as well as how to manage its currency risk across multiple currencies.
Chatham Financial assisted the company in developing a hedging strategy for its debt by explaining the various hedging structures that could be used to create the appropriate hedge of the firm’s interest rate risk. To help the management team obtain an understanding of its currency risk, we worked to isolate the various cash flows by currency and ran sensitivity analysis to determine that 80% of the currency risk could be mitigated by hedging a single currency pair.
Chatham helped execute interest rate swaps of various tenors and types to help isolate the interest rate risk, and executed foreign currency forwards to isolate the company for foreign currency movements over the coming year. The company was able to have a clear understanding of its interest expense and foreign currency risk, which allowed it to ultimately budget and plan accordingly in advance of a volatile year.
Real Estate Case Study: Mezzanine Debt
A nationwide owner of hotels.
Our client’s hotel portfolio was leveraged with a number of long-term low fixed interest rate loans. Since the origination of the original first mortgage debt, increases in operational efficiency for the portfolio resulted in improved portfolio cash flow. Our client’s desire was to use the increased cash flow as a borrowing base to create additional liquidity for new capital investments in the portfolio.
The prepayment penalties associated with refinancing the first mortgages along with the faltering CMBS market made a conventional refinancing cost prohibitive, and market turmoil made traditional, low-leverage, mezzanine debt unavailable. The client engaged Chatham to find a capital partner.
As is typical with our engagements, Chatham’s role started with the strategic planning of the transaction and continued until the deal closed. We spent time with the client running multiple scenarios to determine the portfolio’s sensitivity to shocks in revenue and changes in interest rates. The goal of the analysis was to ensure that any transaction would leave the client with an appropriate level of debt and fixed/floating mix for the hospitality industry, and make certain that the debt maturities were appropriately staggered to minimize refinancing risk.
Once the appropriate capital structure was agreed upon, Chatham created the underwriting and analysis necessary to approach a small number of potential partners who had the capability, experience and flexibility to meet our client’s needs.
After a capital partner was identified and agreement was reached on terms that were mutually acceptable to our client and the capital partner, Chatham proceeded to work with counsel to negotiate the final documents in the agreement and get the necessary consents from stakeholders in the existing financings.
Our client closed a deal with a single capital partner who not only delivered the desired loan size and structure, but also provided the necessary flexibility and capabilities to deal with the complexities of the transaction. The closing provided our client the liquidity to pursue investments in the portfolio at a time when many of its competitors were cutting investments to their hospitality portfolios.
There's no cash transaction in this program, in this project.
The owner owns 15 acre land in certain parts of downtown,
and they want to engage a developer to build a certain asset.
They have specifications for a high rise building, for
garage, for day care center, for laboratories, for cafeteria and so forth.
And at acceptance they will agree to swap the ownership
of the rest of the land that may be 10 acres or
9 acres, whatever is left to the developer.
In that way, the developer can take that land and do whatever they want to do.
They could mix use apartment and office buildings.
They could do any revenue generation project that for
them makes sense for that location.
So the owner in this case, could have gone both ways.
Could have sold the land and developed the project.
Or, in this case, they chose to utilize the market demand of that land and
get a developer engaged to swap it.
So what's the advantage and the disadvantage and
what are the risk of that?
So let's talk about it.
As a project owner, [COUGH] the developed land has more value than undeveloped land.
So if they were to sell the land, they probably would have gotten
lesser value than if they would have done something like this
where they had a developer interested to develop that land.
And this look into the long term.
So there is a market demand and they know about that.
But the market demand will ultimately depend
on what the use of that land will be and how they foresee this happening.
So they could actually take advantage of the market that
is around that to make a deal like this happen.
There is incentive for schedule acceleration,
because if you do a typical project, a contractor may say,
well, when you give me answers, I'll deliver the project.
If it drags two years, you pay me for that delay.
In this case, the developer is interested to do this project as fast as they can so
they can get ownership of the remainder of the land, and
they can start generating revenue out of that.
[COUGH] So their interest of getting this project ready
are aligned and there is an incentive for it.
And the only critical risks that the owner has to really watch for
is quality and scope.
So, as long as they define their scope very well, and
they define the level of quality which is very hard to do,
they will get a very nice project.
Now, for the developer on the other hand, they have to take into consideration
again, that there's volatility in the price of the land as of today.
And granted this project may take a couple of years to develop, so the price of land.
But there's more volatility in the price of the developed land in 10 or 15 years.
So when they look at this in the long-term,
they look at those variables and how they relate to the project and
how they can monetize that to the project.
They're limited by the early written requirements that the project owner
gave them on what they wanted.
So if the owner was not very specific,
they're not going to get a very specific type of building.
But they know that this is what defines what their final outcome is going to be.
And the risk of the vulnerability of the land value, it's
So to, again, illustrate some of this I wanted to see the three entities.
In this case, it's the lender, [COUGH] the developer,
thinking that the developer is not putting their own money but is going to a bank or
to a private institution to get the money to develop this land.
And then, the project owner.
Now, the lender is responsible or
the risk lies, the risk of the final cost of the project lies with the lender.
Because at the end of the day they have the list of specifications and
the project, and they made an agreement to develop
that project with that land, in whatever way they monetize it.
But the final cost of that project, if it goes significantly higher or
lower, it goes back to that lender.
Now, the remaining cost of, the balance cost of the land or
the balance value of the land is also with the lender.
They will keep at the very end the ownership of a piece of
property that its value maybe higher than what they value initially or maybe lower.
So there is something to consider there.
And then if the developer takes longer to deliver this project,
the lender will be there for a longer time with their
money invested without having any return.
So the risk of a schedule extension lies with the lender.
[COUGH] And therefore, this could be a very good thing because the owner will
use that to have a partner to encourage the developer to accelerate.
The developer on the other side has, Has the risk for demand of development.
For instance, if they sign this agreement and this transaction,
and they wanted to do a residential project.
And all of a sudden,
two years down the road, the residential market in this particular area.
And the residential project is no longer feasible,
then the demand will require some other development that they will
be having to really sign and go through the process.
So it may take longer for them to do it.
And then any cost increases
may be a constant battle between the lender and the developer.
And whomever has the higher level of documentation and
justification will win that battle.
So the risk of the cost of the project will be shared
between these two entities, not with the owner.
Which is ultimately the party that typically owns that risk
in a typical transaction, in a design bid build transaction.
Now, as an owner, [COUGH] the major risk is you must define your requirements,
your scope requirements very well.
Your quality is very hard to define, but
you have to find ways to define it very well, because otherwise,
you'll risk not getting the quality of product that you wanted to get.
And therefore, your cost for operations and maintenance may be higher or
lower depending on the level of designed level of quality that you got.
And then, the changes after you award and you sign the transaction of that swap,
any changes that the owner say, I forgot, I want two more laboratories.
Or I forgot we wanted 100 more parking car spaces.
The cost for that, then it go back to the owner,
it cannot be included in the transaction that was already signed.
So that's typically a risk that is shared between the contract and the owner,
in this case it's the owner, the sole provider of that.
[COUGH] Those two cases exemplify how the project financing institutions,
and how the owner looks at the project financing in two different ways.
And how risk gets shuffled and allocated differently
between the different entities, and incentivize different behaviors
between the entities that are participant in a project scenario.
So to conclude this segment, I wanted you to be aware of the uncertainties.
Costs that are not fixed in the program,
have some level of uncertainty and has to be accounted for.
Now, always, always think about using risk-adjusted net
present value and risk-adjusted internal rate of return.
Always look for ways to include that uncertainty in the indicators and
in the ratios that your assessing to make a decision, an investment decision.
And then, [COUGH] be mindful that in a typical transaction,
in a typical financial transaction there is two level,
two layers of uncertainty in each side of the equations.
So the revenue stream is an uncertainty, whether it's as it goes or
whether it's down the road after the project's in operation.
And the cost of the project is another level of uncertainty and
is obviously risk.
So you have to account for both and you have to make comparison,
make those decision based on an informed model that takes
into consideration risk, thank you very much.